Stablecoins regulation reminds me of the classic Western, McClintock, in which John Wayne referees a fight. Wayne demonstrates the behavior he won’t allow by inflicting blows of various kinds on the bruiser about to pummel his young friend. The friend gets knocked out anyway.
Similarly, despite crippling legislation and punishing regulation by the OCC, I expect stablecoins still will prosper as a payment technology. That’s how bad the politically protected status quo is, and how promising stablecoins are. But it will take a lot longer than it should, due to crooked refereeing.
The prohibition of interest payments on stablecoins in last year’s Genius Act was a forceful below-the-belt punch. It provoked circumvention via crypto platform payments to stablecoins holders, but that likely will be limited by the forthcoming Clarity Act making its way through Congress. In olden days, when Regulation Q prohibited interest payments to bank depositors, restricting payments to customers was justified as a means of avoiding “destructive competition” among banks, although its hidden purpose was Senator Glass’s desire to reduce interbank deposits in favor of deposits at the Fed. This time, there is not even a hard-to-fathom rationale for the prohibition of interest. It's just a transparent obstacle to stablecoins’ ability to compete with banks.
Congress also poked stablecoin issuers in the eye with the Genius Act’s requirement that they must redeem stablecoins on demand, which created liquidity risk for issuers akin to risks banks face from uninsured demand deposit outflows. There is no need to require redemption and doing so makes stablecoins less efficient.
My most-cited academic article (with Charles Kahn, available at this link: https://www.jstor.org/stable/2006515) explains why a large fraction of bank deposits, everywhere and always (before regulation required it), have been redeemable. For most financial claims, offering redemption is a demonstrably bad idea. It creates liquidity risk with no offsetting gain. But information problems related to opaque bank lending can create a gain from offering redemption: its discipline encourages banks to manage loan risks carefully.
For stablecoin issuers there is no such gain. They don’t hold loans, just Treasury securities and other assets whose risk is low and readily observable.
But without redemption how will stablecoins trade at par? One approach would be for issuers to mark their portfolios to market, and vary the number of coins a holder owns with changes in issuers’ asset value, keeping each coin at par. Or an issuer could fund itself with sufficient equity (in addition to stablecoins) so that the ups and downs in the value of its portfolio of Treasuries never threaten to reduce stablecoins to a value below par. Issuers that hold longer average duration Treasuries would have to issue more equity than those with shorter asset duration. That approach could be combined with an algorithmic commitment to buy and sell stablecoins in the market (buying at 0.99 and selling at 1.01) to ensure they trade at par value.
Without a redemption requirement, competition likely would have made it disappear as a business practice. Unwise issuers offering redemption (with attending liquidity risk forcing them to hold low-interest cash reserves) would lose market share to issuers with better business models. Regulation prevents that competition and learning.
Adding insult to injury, the OCC referee now is stomping on issuers’ toes by proposing excessive reserve requirements, justified by the liquidity risk Congress created with the redemption requirement. Issuers are effectively required by the proposed OCC rule to maintain at least 10% of their assets in low-interest bank deposits. This requirement is another favor for banks; it limits deposit disappearance from stablecoin competition.
That 10% minimum applies to all issuers, even if their portfolio choices would make them economically immune to the risk of a run, which could be achieved through a combination of sufficient equity funding and sufficiently short average maturity on their Treasuries. Runs occur when an issuer offering par redemption maintains enough average asset duration so that a spike in interest rates leads to a sufficiently large decline in asset value, which creates an incentive to be first in line to get par before the funds run out.
Despite politicians’ and regulators’ efforts to sink stablecoins, stablecoins can still win the fight. Blockchain offers faster, more secure payments, and payments can be combined with other information in new ways to enhance how we transact. Regulation Q was cast aside once it became clear to enough interested parties that it was creating unnecessary harm. I expect it won’t be long before stablecoin holders succeed in stopping referees from interfering in the fight.
